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SUMMARY
trade and capital flows. While we consider the euro a
useful and necessary integration project for Europe,
we believe that in the absence of an appropriate economic governance system it has contributed to the
problems currently affecting Europe. It created a common capital market that eliminated the huge interest
spreads which in pre-euro days had reflected the differences in country-specific inflation and depreciation
expectations, implicitly offering security against
default that it was ultimately unable to deliver. All of
a sudden, cheap credit at lower real and nominal
interest rates had become available to the countries of
Europe’s periphery, in particular the GIPS countries
(Greece, Ireland, Portugal and Spain), lending a boost
to their economies. The cheap credit fuelled a construction boom that brought more jobs and higher
income to construction workers, increasing their consumption and boosting demand throughout the
domestic economy. Furthermore, rapidly increasing
real estate prices encouraged homeowners to acquire
further credit-financed property and created expectations of additional capital gains that triggered even
more such investment. In some countries, in addition,
governments borrowed excessively and boosted
domestic demand via extraordinary increases in government salaries and public transfers.
The financial crisis that originated in the United
States has now turned into a European sovereign debt
crisis. In some European countries it abruptly put an
end to a period of soft budget constraints in which
large capital imports had nourished a process of rapid
growth coupled with rising and unsustainable trade
imbalances. Now a period of hard budget constraints
and belt-tightening has set in, which is likely to reverse
the growth patterns of the past, because capital markets will re-allocate the available savings. The world is
split into capital-exporting countries that are recovering quickly from the shock, and capital-importing
countries that are struggling to get back on their feet.
Western countries attempted to counteract the sudden
recession by resorting to loose monetary policies,
Keynesian recovery programmes and generous bank
rescue operations. However, in the process they have
taken on great burdens and exacerbated a public debt
situation that in some cases was already unsustainable. In 2010, some European states had to go into
intensive care, and others may follow. Obviously, the
world economy is still in turmoil and far from settling
into a new equilibrium.
What began as a useful process of real convergence
benefiting formerly lagging economies eventually
went too far, overheating these economies and creating bubbles that ultimately burst. A ring of
derelict, half-finished buildings surrounds many
cities of the GIPS countries as a mute testament to
overinvestment.
In this 10th EEAG Report on the European Economy
we concentrate on the European sovereign debt crisis.
We shed light on its origins, predict how it will affect
the European economy (Chapter 1) and draw the
lessons for a new economic governance system for
Europe (Chapter 2). The governance system that we
designed and present here would help to manage
future crises, should they occur, while at the same time
imposing the necessary discipline to prevent their
occurrence in the first place. We also have included
separate, in-depth analyses of Greece (Chapter 3) and
Spain (Chapter 4), examining these countries in detail
and outlining the available policy options. A final
piece (Chapter 5), on regulating and taxing the banking sector, completes this year’s analyses.
Today, some of the afflicted economies are stuck with
excessive wages and prices that far exceed the competitive level. While exports are held down by the high
prices, high incomes generate a volume of imports
that is not sustainable, given that the flow of cheap
credit has now ceased. In the years before the crisis
(2005–2008), Greece had a current account deficit of
about 12 percent of GDP, Portugal 11 percent, Spain
9 percent, and Ireland about 4.5 percent. Only Ireland
and Spain have now managed to reduce this deficit
significantly.
A common theme underlying our discussion is the
role that the euro has had on European imbalances in
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EEAG Report 2011
Summary
On the other side of the fence, Germany, which had
exported two-thirds of its savings, or 1,050 billion
euros, since 2002 and had the lowest net investment
share of all OECD countries, stagnated and depreciated in real terms, with wages and prices rising more
slowly than anywhere else in the euro area. The stagnation depressed imports in Germany while the real
depreciation boosted exports, both in a measure sufficient to accommodate the net capital exports largely
caused by the creation of the common capital market.
now the austerity programmes in Europe and the
phasing out of fiscal stimulus measures in the United
States are contributing to the slowdown and will keep
economic growth subdued in most advanced
economies during 2011.
We expect world GDP to increase by 3.7 percent in
2011 and thereby fall back to what can be considered
its long-term average. Not all regions will contribute
equally to this development. Once more Asia will
deliver the strongest contribution. The two larger economic areas, North America and Europe, will remain
below their potential.
We believe that Europe will have a hard time redressing these imbalances. The solution cannot be to call
the euro into question, but for Europe to overcome its
regime of soft budget constraints, resorting to a
regime exhibiting a more prudent investment behaviour, based on the principles of liability and responsibility. It also needs a system of generally accepted
supervision and codes of practice in the financial
industry, as well as tight public debt constraints so as
to tame the excessive and unhealthy capital flows that
caused the crisis. Once such a system has been established, the current difficulties of the euro may turn
out to be mere teething problems in what ultimately
will become a success story in the process of European integration.
In the United States, due to its continuing structural
problems, a strong self-sustaining upturn is not in
sight. The ongoing recovery in quite a number of
European countries remains subdued, mainly as a
consequence of the dampening effects of highly
restrictive fiscal policies and the hesitation of capital
markets to continue providing cheap finance to the
capital-importing countries. In most emerging markets, the pace of expansion remains comparably high.
Nevertheless, growth rates will stay below the levels
reached last year. World trade, which last year
increased by about 12 percent, will return to normal
and accordingly record a growth rate only about half
as high. The remaining underutilisation in many
advanced economies and more moderate growth in
the emerging world will keep inflation rates low.
Chapter 1: Macroeconomic Outlook
When the world recession ended mid-2009, it was
unclear which letter would best describe the subsequent shape of the world’s recovery process: V, L and
W were among the candidates. Today, it is clear that
the recovery was V-shaped, proving the optimists
right. After it shrank by 0.6 percent in 2009, the world
economy showed a rebound and is expected to have
reached a growth rate of 4.8 percent in 2010. World
trade expanded quickly for four quarters in succession. Whereas industrial production in the emerging
and developing countries has returned to its longterm growth path and surpassed its pre-crisis level, in
most advanced countries it is still far below its pre-crisis levels. Here, on average, not even half of the drop
has been regained since spring 2009, and capacity utilisation rates in industry are therefore still at historically low levels.
Economic and political discussion in Europe last year
centred on the sovereign debt crisis. Concerns regarding the solvency of countries like Greece, Ireland,
Portugal and Spain have led to high interest rate
spreads on government bonds for these peripheral
countries vis-à-vis Germany’s. In spring 2010, the
finance ministers of the euro-area member countries
together with the IMF agreed on the establishment of
an emergency fund to help these governments in
financial distress. Although the European sovereign
debt crisis is about illiquidity or potential insolvency
of individual member states, the interconnectedness
in terms of cross-holdings of sovereign debt within
the European banking sector also makes it a concern
of inner-euro area financial stability. The ECB is
therefore keeping an eye strongly focused on the stability of the financial system and in effect has begun
bailing out endangered countries.
During the course of 2010, however, the recovery of
the world economy slowed down. Whereas
economies could still benefit from stimulus measures,
a rebound in inventories and a general recovery of
the economic climate during the first half of last year,
EEAG Report 2011
The differences between the individual member countries remain substantial. In the capital-exporting
countries, which have relatively sound public finances
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Summary
and few structural problems, such as Sweden,
Finland, Germany, Denmark, Austria and the
Netherlands, growth is expected to be above average,
as capital is now increasingly reluctant to leave the
home country. Unemployment in these countries is
likely to fall during the year. In the capital-importing
countries of the European periphery, however, the
tightening of public and private budget constraints
imposed by the capital markets will continue to dampen growth. The recovery will only come slowly, as in
Italy, Spain and Ireland, or the economies will remain
in recession, as in Greece and Portugal. All in all,
GDP in the European Union is expected to increase
by 1.5 percent this year, after 1.8 percent in 2010.
tions softer and softer. Obviously, the political debt
constraints that the European countries had imposed
on one another never worked.
Only the market constraints worked. Admittedly, the
markets put a stop to this deleterious European development too late and too abruptly. But at least they
stopped it dead in its tracks.
Thus we believe that a good economic governance
system that would discipline the European countries
should not try to circumvent the market but use its
disciplinary force in a way that will allow for a finetuning of the necessary checks to excessive public borrowing. In addition, such a system should provide a
limited degree of protection to investors buying government bonds, helping to prevent panic in the case of
a crisis as well as avoiding unlimited interest spreads,
making it unlikely for governments to be unable to
borrow from the international capital markets. In
short, we seek a system that protects against insolvency without degenerating into a full-coverage insurance
free of any deductibles.
After current account balances were significantly
reduced in 2009 in absolute terms, last year saw a
moderate step back towards pre-crisis levels. The
increase among those countries running current
account deficits was almost solely due to the United
States and the United Kingdom. The demand impulses the governments of these two countries set were
met by increased net exports of most of the surplus
economies. Of these, only China was an exception to
the rule. Albeit at a slower pace than the year before,
it continued to reduce its current account surplus,
while its strong domestic growth gave further impulses to the rest of the world. Furthermore, most other
deficit countries, in particular Spain, Italy and
Greece, have successfully started to improve their
trade balances because of the increasing difficulties to
find the capital to finance them.
We propose a three-stage crisis mechanism that is
based on the EU countries’ decisions of 16–17 December 2010, in particular the establishment of a
European Stability Mechanism (ESM), specifying in
more detail how these decisions could be implemented. We distinguish between illiquidity, impending
insolvency and (full) insolvency, placing most emphasis on the second of these concepts, because it acts as
a ”breakwater” barrier aimed at forestalling a full
insolvency.
Chapter 2: A New Crisis Mechanism for the Euro Area
First, if a country cannot service its debt, a mere liquidity crisis will be assumed, i.e. a temporary difficulty due to a surge of mistrust in markets that will soon
be overcome. The ESM helps to overcome the liquidity crisis by providing short-term loans, senior to private debt, for a maximum of two years in succession.
This time span should be long enough for the country
to raise its taxes or cut its expenditures so as to convince private creditors to resume lending.
Ideally, the public debt constraints that Europe
imposed with the Stability and Growth Pact, which
basically forbids deficits exceeding 3 percent of GDP,
would have sufficed to instil the necessary debt discipline in the euro area. However, the pact was clearly
inadequate because it was never really respected.
Until 2010, the records for the European Union show
97 (country/year) cases of deficits above 3 percent.
Less than one-third of these cases (29) coincided with
a significantly large domestic recession, so that in
principle they could have even been justified on the
basis of the original stipulations of the Pact. Still,
there was no ground for justification in the remaining
68 cases, and thus sanctions could and should have
been imposed. In fact, however, that never happened.
Member states were ready to “reinterpret and redefine” the Pact, again and again, to make the condi-
Second, if the payment difficulties persist after the
two-year period, an impending insolvency is to be
assumed. Collective Action Clauses (CACs) in government bond contracts ensure that a country can
choose a piecemeal approach when trying to find an
agreement with its creditors, dealing with one maturity of bonds at a time without holders of other
maturities having the right to also put their claims on
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EEAG Report 2011
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the table. The ESM in this case provides help in terms
of partially guaranteeing (up to 80 percent) replacement bonds that the country can offer the creditors
whose claims become due, but only under the condition of a haircut for the respective loan maturities.
The haircut will see to it that the banks and other
owners of government bonds bear part of the risk of
their investments. As the haircut will, within limits
(20 to 50 percent), be sized on the basis of the discounts already priced in by investors, it will clearly
help stabilise markets.
do nothing but strengthen incentives for opportunistic behaviour on the part of debtors and creditors,
given that they prevent the emergence of fundamental
risk premiums, by acting as full-coverage insurance
against insolvency. Appropriate pricing of sovereign
risk is an essential feature of well-functioning financial markets. It induces debtors and creditors to keep
capital flows within reasonable limits and to exercise
caution in lending. This is the essential prerequisite
for correcting European trade imbalances in future.
Third, should the country be unable to service the
replacement bonds and need to draw on the guarantees from the ESM, full insolvency must be declared
for the entire outstanding government debt. A collective debt moratorium covering all outstanding government bonds will have to be sought between the
insolvent country and its creditors.
Chapter 3: Greece
During the spring of 2010, it became clear that the
Greek government was in serious financial trouble
and needed massive support. In May a gigantic rescue
package was put together by the European
Commission, the ECB and the IMF, in order to help
Greece and reduce the risk of contagion to other EU
member states. This chapter discusses whether the rescue package will meet its intended goals and prove
sufficient to help Greece onto a sustainable path without the need for further support after the expiration of
the current package in June 2013.
The CAC bonds, backed by partially guaranteed
replacement bonds, provide a possibility for troubled
European countries to address their financing needs
immediately. As these bonds define and limit the risk
to investors, they provide a key instrument for countries to raise money from the market without having
to resort to the funds of the ESM. For instance, issuing these bonds can make it possible for these countries to repurchase debt at today’s discounted market
values, with the goal of significantly reducing their
debt-to-GDP ratios.
Greek government spending experienced a huge
expansion during the 1980s, without a countervailing
increase in government revenues. During the 1990s
recorded deficits fell considerably, but in the year 2000
they started increasing again. Despite moderate
deficits between the mid-1990s and the mid-2000s and
fast growth in nominal GDP, government debt
increased even relative to GDP. We show that this was
partly due to excessive government spending and
partly due to off-budget activities: during the 1990s
various outstanding liabilities had to be consolidated
into the government debt. In 2009, the accumulated
effect of these off-budget items had contributed to the
outstanding debt relative to GDP by more than
60 percentage points. A successful return to sustainable public finances requires full control of the development of these off-budget items.
The key prerequisite for maintaining market discipline is the sequencing and relative size of the haircut
and government aid in the case of pending insolvency.
Before financial aid in the form of guaranteed
replacement bonds may be granted, the creditors must
initially offer a partial waiver of their claims. Only
this order of events – with defined maximum losses
for the investors – can guarantee that the creditors
apply caution when granting loans and demand (limited) interest mark-ups. The interest mark-ups are an
indispensable disciplinary device of markets that
ensures that over-indebted countries have an incentive
to reduce their demand for credit.
At least as worrisome as the fiscal situation is the
external balance. As compared to any other EU15
country, Greece experienced the strongest decline in
national savings over the past decades. As a consequence, the current account balance started deteriorating in the mid-1990s, a process that subsequently
accelerated. After 2004, current account deficits
added almost 50 percentage points to net foreign
debt relative to GDP, which stood at around 100 per-
No crisis mechanism should be instituted in Europe
that again eliminates interest spreads, as happened in
the first years of the euro. In particular, the euro area
should under no circumstances move to eurobonds as
advocated by some European politicians. We can only
warn that issuing such bonds will exacerbate the problems we see at the root of the crisis. Eurobonds could
EEAG Report 2011
12
Summary
cent in 2010. This huge debt build-up, far above the
widely accepted “danger thresholds” of 40 to 50 percent of GDP, accumulated over a relatively short
period of time. Net foreign debt was in fact close to
zero in 1997.
private markets, at default-avoiding interest rates, for
all its borrowing needs when the bailout package
expires in June 2013.
The new kind of government bonds we describe in
Chapter 2, however, might offer a solution to Greece.
As these bonds provide security to investors insofar as
they will be convertible – after a limited and welldefined haircut – into replacement bonds that are partially secured by the ESM, Greece should be able to
refinance its debt in the market if it offers its creditors
appropriate interest margins over safer kinds of
investment.
Compared to other euro-area countries faced with fiscal problems, a number of features of the Greek economy pose particular difficulties. Greece has a very
high share of self-employed, at around one third of
total employment – the highest share in the OECD.
Underreporting of income is likely to be much higher
among the self-employed, reducing the effective size
of the tax base. Underreporting also has distributional consequences. For example, more than 40 percent
of self-employed doctors practicing in the most lucrative (for medical professionals) area of Athens reported an income below 20,000 euros in 2008. If this is not
changed, popular support for needed fiscal consolidation will be undermined. Fighting tax evasion must be
a key focus for future reform. In addition to more
direct measures, further increases in VAT rates, coupled with reductions in social security contributions,
should be considered. This type of budget-neutral tax
substitution reduces the effective tax advantage of
non-traded activities and it promotes the development of the export sector. Thus, over time this policy
could help restore both fiscal and external balances.
Regardless of whether Greece’s sovereign debt crisis
can be resolved, there remains the problem of how to
get rid of the huge and unsustainable current account
deficit. There are, in principle, only three options;
i) exiting the euro and introducing a devalued drachma, ii) a radical internal depreciation, with Greek
prices and wages falling sharply relative to those in
the rest of the euro area, and iii) an ongoing transfer
program from the European Union to finance the
deficit. We discuss these options in detail. We rule out
the third alternative of ever-continuing transfers
from the European Union to Greece as a viable solution. A key argument against transfers is that they are
very unlikely to help a region with structural problems to gain international competitiveness, as demonstrated by the negative experience of the transfers to
eastern Germany over the last two decades. The first
two options, external and internal depreciation, both
impose very large costs and will not work quickly.
Both will increase the burden of foreign debt
expressed as a share of GDP and have dangerous
effects on the balance sheets of many firms and
financial institutions. An internal depreciation as
large as required can certainly not be achieved without a painful and sustained contraction of the economy and higher unemployment. An external depreciation is likely to be preceded by rumours that can
cause a bank run and lead to a currency crisis. There
is therefore no alternative that is clearly more palatable than the other in every respect. The choice is
between two evils.
The self-employed are largely shielded from international competitive pressure, which is an important
reason for the low competitiveness of the Greek economy. Greece has an extraordinarily high share of services in total exports, of which a large share is shipping services. Net exports of services (including shipping) have been consistently more than 5 percent of
GDP. In contrast, net goods exports have been registering very large deficits, sometimes exceeding 15 percent of GDP. This creates a situation in which a real
exchange rate depreciation can – via substitution
effects – only very slowly reduce the current account
deficit. An expansion of the export sector sufficient to
restore a sustainable external balance is not likely to
occur soon. Instead, the required adjustment will
most likely have to come from a fall in imports, via
reductions in wealth and income. The conclusion is
that it is likely that Greece will see a number of years
with output far below potential and very high unemployment rates. Although such a development might
help in reducing the current account deficit, it makes
it more difficult to achieve fiscal balance. In our opinion it is thus unlikely that, with normal debt instruments, the Greek government will be able to return to
Chapter 4: Spain
For more than a decade before the current crisis,
Spain was hailed as a success story. After a period of
weak economic performance characterized by pathologically high unemployment rates, its growth rate
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EEAG Report 2011
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accelerated and exceeded the EU average, its fiscal
outlook improved and unemployment started to fall
to normal levels by European standards. It benefited
from joining the European Monetary Union, which
gave it a fiscal windfall in the form of a very rapid
convergence of interest rates to the European levels:
Spain no longer had to pay a premium for its inflation
risk in the form of higher interest rates.
softened had the Spanish government embarked on a
programme of reforms early in the crisis. This would
have yielded credibility to Spanish economic policy
and implied less financing constraints from the international capital markets. Unfortunately, such reforms
were never implemented.
Such reforms would, however, be necessary to reallocate labour to the external sector in order to restore
the internal and external balance, and to bring about
productivity gains strong enough to mitigate the
reduction in real wages that are necessary for the
adjustment. These ingredients are necessary for
Spain to correct its large imbalance in the external
sector, which is a required component of any fiscal
consolidation package. We stress the need for
reforms of the employment protection legislation
and the system of collective bargaining, as well as
reforms in product markets that would enhance competition and the need for Spain to improve the quality of its R&D and higher education systems. The
emphasis has to move from infrastructure investments to human capital formation.
This “Golden Decade” has come to an abrupt end,
however, as Spain has been severely hit by the crisis. It
has suffered from widespread job destruction that has
pushed unemployment back to above 20 percent. A
severe contraction of GDP has generated large budget
deficits and Spain has been punished by financial
markets that have imposed on it higher spreads than
for Italy and Belgium, albeit still lower than for
Greece, Ireland or Portugal.
We discuss the performance of the Spanish economy
before as well as during the crisis, highlighting a number of weaknesses that cast doubt over the sustainability of the boom years. During those years, the
Spanish economy specialised in low-skill-intensive
services and construction; it accumulated positive
inflation differentials with respect to the rest of
Europe, which eventually created a competitiveness
problem and contributed to very large trade deficits,
in spite of a dynamic export sector that maintained a
satisfactory performance but did not grow enough to
offset the large increase in imports; total factor productivity was low and most of the growth was due to
the reduction in unemployment, together with large
immigration flows.
In particular, we endorse a proposal made in 2009 by
100 economists that would allow for agreements at the
company level to supersede any sectoral agreement,
for example, if the lower level agreement implied
lower wage growth than the sectoral one. Thus, sectoral agreements would only define a default option in
case bargaining does not take place at the company
level. At the same time further steps must be taken to
end the duality of protection in the labour market as
well as reforming unemployment subsidies so as to
incentivise job search.
Furthermore, during this period very little was done
to tackle structural rigidities in the labour and product markets. These rigidities account for a low potential for long-term growth and reduce the economy’s
capacity to absorb shocks. Hence in the current crisis
wages grew by more than 3 percent despite the huge
hike in unemployment. The structural rigidities that
account for the poor labour market performance of
the 1980s were merely papered over by the boom of
the Golden Decade. We thus fear that after the crisis
is over, a period of very high unemployment may prevail in Spain.
We also emphasise reforms that would make the public sector more efficient, as well as a liberalisation of
barriers to entry in the service sector and productivity
improvement in small and medium-size enterprises.
The speedy reform of the financial sector after the
adverse real estate shock is crucial to provide adequate credit to the economy. The aim must be to raise
total factor productivity growth, which has been disappointing so far and will play a key role in increasing
exports and mitigating the short-term negative impact
of structural reforms on living standards, thus making them more politically acceptable.
The crisis has intensified the need for reform, with the
government facing the twin challenge of achieving
rapid fiscal consolidation to calm down markets and
avoid insolvency, and of implementing structural
reforms. The contractionary policies could have been
EEAG Report 2011
The crisis offers a unique opportunity to pass a comprehensive reform package. The only question is
whether Spanish society and its politicians will take
advantage of this window of opportunity.
14
Summary
including only economic rents and the remuneration
of very highly paid employees. This would in principle
be non-distorting, and so would not create uncertain
and complex interactions with the regulatory regime.
However, if revenue requirements are sufficiently
high, it may require a high rate. At the other extreme,
all remuneration could be included in the tax base.
This would be similar to a tax on the value added.
Since its base is larger, the rate could be lower. This
version could be seen as a substitute for the absence of
VAT in the financial sector, although the form of the
tax would differ from VAT, and a number of technical
details remain to be resolved. Either form of the tax
could be introduced alongside existing corporation
taxes.
Chapter 5: Taxation and Regulation of the Financial
Sector
Since the onset of the financial crisis, governments
have been searching for policies to offset the costs of
bailing out the financial sector, and to put in place
structures to reduce the probability and severity of a
future crisis. The last chapter of our report examines
proposals that have been considered, and enacted, for
new taxes on banks and other financial institutions,
analysing these taxes in the light of existing and new
regulations on the financial sector. The chapter
focuses primarily on regulations that are related to
tax proposals.
The chapter begins by briefly reviewing the causes of
the recent financial crisis, identifying the key factors
that need to be addressed by taxation or regulation. It
then summarises existing work on the choice between
taxation and regulation as alternative ways of dealing
with negative externalities imposed by one company,
or one sector, on the rest of society.
A second objective of a new tax in the financial sector
could be to help make a future crisis less likely, by
inducing banks and other financial companies to
reduce leverage or to invest in less risky assets. One
option for this objective is the Financial Securities
Contribution (FSC) also proposed by the IMF.
Basically this is a tax on the bank’s balance sheet that
exempts the equity capital and insured assets but
includes off-balance sheet operations. Several countries have either introduced, or announced that they
plan to introduce, such a tax. While this tax is partly
designed to raise revenue, it is also clearly intended to
reduce leverage.
The key policy analysis of the chapter relates to two
alternative objectives for new taxes on the financial
sector: i) raising revenue, and ii) inducing behavioural
change that will make another crisis less likely.
From a forward-looking perspective, the first objective would be to raise revenue that could be used to
build a resolution fund for the next crisis. We consider two possible approaches to the design of a tax base
for such a purpose. One is a form of insurance premium, where the tax reflects the risk that an individual
company will require support from the resolution
fund and the amount of support that it would require.
Such a tax would be complex, however, since it would
need to be based on factors that reflect the financial
fragility of the company, its size and the degree to
which it is systemically connected to the rest of the
sector. It would almost certainly affect the behaviour
of banks and other financial companies, possibly
inducing them to reduce leverage and the risk of their
investments. However, these effects would depend on
the form of the tax, and there is a danger that it could
have unexpected consequences if introduced – as it
almost certainly would be – alongside regulations on
capital and liquidity requirements.
In principle, this tax could be a meaningful addition
to a Tier 1 capital regulation, as it would also lead to
a higher capital ratio relative to all assets – including
government bonds, which are currently not included
in the sum of risk-weighted assets in the Basel system.
The FSC, similar to a minimum capital requirement
as it is included in Basel III, is independent of the risk
of the bank’s assets. It is likely that a bank would
respond to a higher capital ratio – induced either by
the FSC or by the minimum capital ratio – by shrinking its balance sheet through a reduction of its holdings of government bonds, whose risk is not measured
by the Basel regulations, while maintaining its equity
capital. This would increase the ratio of capital to all
assets, while maintaining the same ratio relative to
risk-weighted assets. Such a strategy would raise the
average risk of its remaining assets, but this would be
more than offset by the higher capital ratio, implying
that the probability of default would fall. However, it
is also possible that a bank could follow a different
strategy that would increase the probability of
default.
Another option, better geared towards raising additional revenue, would be the Financial Activities Tax
(FAT) recently proposed by the IMF. This has two
possible forms. We would favour a narrow base,
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EEAG Report 2011
Summary
We review evidence on the minimum capital requirements that are necessary to equate marginal social
costs and benefits. Based on this evidence, the highest
requirements under Basel III should be seen as a
lower bound of what is socially optimal. It is likely
that additional social benefits would be achieved by a
higher ratio, though these benefits would probably be
relatively small. We propose that these requirements
should continue to be set by regulation, while we are
more insecure about the role of a tax. A minimum
capital asset ratio is a possibility, but the required
ratio should be higher than 3 percent.
Additional tax revenue might, however, be useful in
establishing a crisis resolution fund. Options for taxation include taxes, such as the FAT, intended to raise
revenue in a relatively non-distorting way, as well as
taxes, such as the FSC, that are intended to supplement regulation. The main case in favour of the latter
stems from an attempt to overcome the deficiencies of
existing regulation; its value may therefore depend on
whether it is instead possible to reform the regulation
directly.
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